PeoplesHR Limited (ASX:PHR) delivered a less impressive 8.72% ROE over the past year, compared to the 9.48% return generated by its industry. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into PHR’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of PHR’s returns. View our latest analysis for PeoplesHR
What you must know about ROE
Return on Equity (ROE) weighs PeoplesHR’s profit against the level of its shareholders’ equity. For example, if the company invests A$1 in the form of equity, it will generate A$0.09 in earnings from this. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for PeoplesHR, which is 8.55%. PeoplesHR’s ROE exceeds its cost by 0.16%, which is a big tick. Some of its peers with higher ROE may face a cost which exceeds returns, which is unsustainable and far less desirable than PeoplesHR’s case of positive discrepancy. ROE can be broken down into three different ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
Dupont Formula
ROE = profit margin × asset turnover × financial leverage
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = annual net profit ÷ shareholders’ equity
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue PeoplesHR can generate with its current asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine PeoplesHR’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 5.76%, which means PeoplesHR still has headroom to take on more leverage in order to increase profits.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Although PeoplesHR’s ROE is underwhelming relative to the industry average, its returns are high enough to cover the cost of equity. Also, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.